From being an economy with virtually no foreign investment in the late 1970s, China has
become the largest recipient of foreign direct investment (FDI) among developing countries
and, for many years, has been second only to the United States in terms of FDI receipts.
FDI inflows exploded from $5.9 billion to $115 between 1985 and 2003. Since 1994, China
has attracted about one third of total FDI to emerging markets each year and about 60% of
flows to Asian emerging markets (Prasad and Wei, 2005).
Economists usually agree that FDI flows to countries having a high market potential, stable
macroeconomic environment and commitment to market reforms as well as high
productivity, low costs of labor and good infrastructure among other favorable conditions.
In the case of China, Huang (2003) argues that the large inflow of FDI is not only the
consequence of growing market and good policies, but also results from certain distortions
in the Chinese banking market and in state investment policies. He states that “Primary
benefits of China’s FDI inflows have less to do with the provision of marketing access and
know-how transfers, technology diffusion, or access to export channels, the kind of firmlevel
benefits often touted in the literature. Instead, the primary benefits associated with
China’s FDI inflows have to do with the privatization functions supplied by the foreign
firms in a context of political opposition to an explicit privatization program, venture
capital provisions to private entrepreneurs in a system that enforces stringent credit
constraints on the private sector”.
After the opening of the market for foreign investors, the discrimination against Chinese
private firms continued, leading to the weak protection of property rights and a lack of
market opportunities. As early as 1982, the adopted Chinese constitution protected the legal
rights of foreign enterprises. Only in 1999 was there an amendment made to acknowledge
that the Chinese private sector was an integral part of the economy, putting it on equal
footing with state-owned enterprises. A major problem in China’s corporate sector is a
political pecking order of firms which leads to the allocation of China’s financial resources
to the least efficient firms – state-owned enterprises – while denying the same resources to
China’s most efficient firms – private enterprises. Private firms are discriminated against in
terms of access to external funding, property rights protection, taxation and market
opportunities. Park and Sehrt (2001) show that lending by state banks is determined by
policy reasons, rather than by commercial motives. Such distortions may force private
Chinese firms to look for a foreign investor